Biotech business development is out of whack!  Something needs to be done fast or the best, brightest, and most experienced will leave their companies.  Below is an example of what is wrong with biotech BD and what can be done to fix it.

Suppose senior investment bankers get paid a small base, say $200K, and a bonus usually with an extra zero on it.  Biotech Chief Business Officers (CBO) likely receive anywhere from $200-300K in base salary and possibly 25% in bonus compensation with a ~2% equity kicker vested over 4 years (not counting re-vesting for re-greening).  How can two people who both are arguably transaction professionals doing largely the same thing (yes I know there are differences) get paid in such radically different ways?

Three questions that you should think about:

• Which person is more financially motivated based on these structures?
• Who does more deals? and
• Which person has more variability in compensation?

Answers:

• Banker
• Banker
• CBO (yes it’s true, I’ll get to it in a second)

A senior banker is basically paid a percentage of revenue, which is directly related to closing deals.  He/she might work on 10-20 deals a year and close 2 or 3 if not more.  Let’s say the average success fee is $5M.  That’s $10-15M in revenue, of which maybe 10% gets paid out to the lead banker equating to $1-1.5M.  The $200K base plus $1-1.5M in bonus is $1.2-1.7M in annual compensation.

The CBO gets his/her $250-350K in cash compensation including bonus and depending on the type of company, might be involved in one deal every year or every other year (they might not do any deals if the technology fails or they company needs more data).  What if, though, that deal is not an exit, and there are no more deals to be done at the company?  It doesn’t make sense to stick around anymore waiting for the equity to vest and hoping for an M&A.  Let’s say this BD deal happens two years into your four year vesting cycle.  The CBO only earned 1% of the company and hasn’t realized any value from that equity.  He/she now has to make a decision whether or not to buy those shares, not knowing if they will ever be worth anything (for private companies only).  How many biotech companies exit for large sums?  In 2009, 19 private venture backed companies exited out of thousands potentially for sale.  A BD exec would be lucky to get one good one in a career.  Two is like getting hit by lightening.  A typical “homerun” of $300M x 2% = $6M if you’re there at exit and assuming all VC preferences have been washed away.  $300M x 1% is $3M, but more often than not, you will be heavily diluted after leaving the company and after they raise more capital.  Your 1% might end up as 0.5% or 0.25%.  On a $300M exit that is worth $1.5M or $0.75K.  That equates to $750K or $375K in “bonus” per year.  What if you only have one of those in a 20 year career?  Many companies don’t ever get a deal or an exit.  That is <$100K in “bonus” per year and is highly variable.  Bankers’ bonuses have much lower variability (much higher risk adjusted value) compared to M&A exists for biotech BD execs.

What does all of this math mean?  Bankers have a much better deal financially and one of three things needs to happen:

• Biotech companies with one or two products need to hire bank (who need to learn how to do business develpoment, not just M&A)
• They need to hire Locust Walk Partners (sorry for the self serving commercial), or most likely
• They need to compensate their business development professionally in a radically different way to properly incent these professionals financially.

Equity options in a company and success fees that could be paid for a transaction can and often have little correlation in economic value, especially in private companies.  I suspect that if this paradigm doesn’t change, either the best BD professionals will start competing shops to Locust Walk Partners or they will leave the industry entirely where their skills will be more highly valued (like in banking).

This was not mean to be a white paper in favor of Locust Walk but rather to illustrate a point that CEOs and VCs might not have the right mix on how to extract the maximum value from their important business development professionals.  Let’s see if they can figure it out!

Today I listened to a very interesting, albeit brief, discussion about pre-negotiating the exit before the initial investment at the Venture Panel at the 2010 Wharton Health Care Business Conference.  The moderator asked about structured transactions where the upside is capped by way of an option with a pharma company to purchase the asset/company after a predetermined milestone.  The panelists were almost all bullish on this idea with some suggesting that they employ this with great frequency.  While I’m not surprised, I do think it has become much more acceptable than before given the continued poor exit environment.

Brenda Gavin, Partner at Quaker BioVentures, mentioned that there were only 20 M&A exits in 2009 from venture backed companies that would constitute a good return.  She mentioned that there are 3,400 biotechs, all of whom are for sale at any given point.  The exit ratio therefore isn’t so good, especially with effectively no IPOs taking place.  As such, if a VC can pre-negotiate a “4x” as she mentioned, she would take that any day over an uncertain 10x.

Steven St. Peter from MPM commented on the MPM/Novartis strategic fund as well as other non-disclosed deals of a similar option nature with other pharma companies.  He said their fund was doing these deals since 1996, but it wasn’t formalized until 2006 with Novartis.  His interesting insight is that there is a real range of exit values for biotech M&A.  Given the amount that generally needs to be invested to get there, there already is an effective cap on returns.  There might be one outlier per year but you can’t set-up your fund expecting outliers.  Given the effective cap on M&A returns, why not cap your return earlier to derisk the exit?  This makes perfect sense to me and something that was mentioned in this blog half a year ago.

Pharma companies rely on biotechs for a supply of innovative assets to fill their pipeline.  They need the VCs to make these risky investments to fund the early stage development.  More companies will be asked by their board to find a partner prior to the next round of financing both to derisk the round as well as provide validation.  This type of pre-negotiated exit arrangement I predict will become even more common going forward as VCs try to improve their returns.

Today we revealed the results of our buy-side BD survey about licensing best practices at the FierceBiotech Webinar titled "Partnering with Pharma: How to Get a Deal".  On the panel with us were Ad Rawcliffe from GSK and Anna Protopapas from Millennium/Takeda.  One major takeaway from Ad and Anna's presentation was the need for a strong relationship between the licensors and pharma/biotech partners.  Clearly this is more important for a partnership than it is for an outlicense or an M&A.  We could not agree more with this sentiment.  The problem is that it's very hard and time consuming to establish a relationship with every partner who expresses an interest.  Something that most biotech companies don't fully appreciate is the need for the entire senior managemet team to get engaged with partnering discussions, not just the CBO/BD team.  While BD at a small company does more than simply facilitate, they need to make sure that they get their team fully engaged to make a deal work.  Ultimately you need a clinician or scientist speaking with the partner's clinical champion to get them excited, not a business bozo.  For more musing or to get a copy of a six slide overview of the presentation that Jay and I shared, please send me an email at geoff@locustwalkpartners.com.

I had a very interesting conversation on Friday with a business development executive from a major pharmaceutical company (both shall go unnamed to protect confidentiality).  He had read my posting about negotiating the exit before the entry and was very intrigued. He told me that his company had started exploring this idea several months ago.  They were very attracted to the idea of getting a quality asset without having to pay venture homerun-like returns for the product.  Unfortunately the VCs that were approached were not interested.

If entrepreneurs would be willing to cap their upside (albeit with downstream economics that can improve the final number) and pharma companies are interested in making this type of commitment, there has to be a way to attract funding.  What investors in this market wouldn’t want a completely uncorrelated 2-3x return with potential longer term upside?  My guess is that eventually the VC community will stubbornly come around and invest at least part of their portfolio with this concept.

The other answer is to start a fund whereby the top 5 pharma companies all agree to share these deals with a pre-negotiated exit with the new fund.  The entire remit of the fund would be to fund these companies.  While the upside for each individual investment might not be gigantic, the downside theoretically is much less given it has gone through “pharma diligence” rather than “VC diligence” which is arguably much more thorough and has a much higher success rate.  Anyone willing to give me $300M to make this happen?